Readers of my columns know that one of the guiding principles of my trading is to follow short interest. In fact, one of my 10 Trading Commandments (No. 6, to be precise) is "Short sellers are usually a bull's best friend."
Why have I been so successful using short interest? It's all about the "squeeze" that happens when a heavily shorted stock starts to rise.
That's when short sellers are forced to "cover" their losing positions on a stock. This results in unusually strong buying volume that drives a stock price higher.
I filter the bi-weekly short interest data from the exchanges to identify stocks with unusually high short interest. What's unusual? My Best in Breed (BIB) model searches for short-interest ratios (short interest divided by the average daily trading volume) above 6.0.
In addition, the model searches for increasing short interest, indicating that the shorts are adding to their bets against the stock.
Today, my BIB model told me that biotech is the most heavily shorted sector in the market right now. In fact, the SPDR S&P Biotech ETF (XBI) is the only ETF with a double-digit weighted component short interest ratio.
The current ratio of 10.7 is rare among ETFs, so I drilled down on the sector to look at individual stocks that are contributing to the elevated short interest.
While there are several stocks with high short interest, I filtered the results for those in a strong technical uptrend as defined by trading above their rising 50-day moving averages.
My models show that the odds of a stock moving higher double when the 50-day moving average is trending higher.
It's this combination of high short interest (bearish sentiment) and bullish technical strength that creates a short squeeze situation and gives me the "best of the best" bullish stocks.
Running the filter produced two names that stood out, so let's take a look at each one...
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After Its Initial Jump, This Stock Hasn't Looked Back
First up is Exact Sciences Corp. (NASDAQ: EXAS), which develops diagnostic tools for detecting various cancers, most notably colorectal cancer and precancer.
Founded in 1995 in Madison, Wis., the company has a market cap of just under $10 billion.
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Exact Sciences is up around 50% for the year, mainly because of an agreement it entered in mid-August with Pfizer to co-promote Cologuard, its colorectal screening test. The stock jumped sharply in the week following the news and has been climbing since.
Exact Sciences gained 5% in September, using its rising 20-day moving average for support and setting a series of all-time highs. Note that the 50-day moving average is also trending higher.
Of course, Exact Sciences is on my radar because of its short-interest ratio, which more than doubled to a robust 9.4 in the latest data report.
With the stock trading just below record-high territory, the prospects for a short-covering rally are highly likely.
What's more, last month several analysts raised their price targets for the stock, suggesting to me that Exact Sciences is in for a strong fourth quarter.
To be fair, let me add that last week one research company called Exact Sciences its "best new short idea," which caused the shares to drop 3% in one day. But the stock found strong support at the 20-day moving average and regained the loss in two days to reiterate the stock's underlying strength.
With the company reporting earnings in late October, the Nov. 16, 2018 $80 call allows plenty of time for a short squeeze to propel the shares to new highs.
This Year Saw This Beast of a Stock Double in Value
The second stock on my radar is Sarepta Therapeutics Inc. (NASDAQ: SRPT), which develops gene-based treatments for neuromuscular diseases. Sarepta has gained more than 160% after doubling in 2017.
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Other than a pullback in June and July, which was well supported by the 50-day moving average, it's been all uphill for Sarepta for more than a year. Now, the 20-day moving average is doing its part to keep the stock's strength intact.
Despite the monster rally, short interest has been going up, as well. In fact, the short-interest ratio has been steadily advancing since July 2017, a period in which the share price has exploded more than four-fold.
With the current ratio sitting just below 9.0, there's plenty of shorted shares to fuel a covering rally.
There's no doubt that biotechs involved in high-level research and development are constantly walking a regulatory tightrope.
All it takes is one negative FDA ruling to send the share price tumbling. Perhaps that's what the shorts are banking on.
But the company has navigated these dangerous waters so far, and so long as you keep your position size small, it's a risk worth taking... especially with so many doubters betting against the stock.
Option prices are not cheap on Sarepta and bid/ask spreads are on the wide side. Nevertheless, look at the Jan. 18, 2019 $150 call as an intermediate-term bullish play that should accommodate some short covering.
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About the Author
Chris Johnson (“CJ”), a seasoned equity and options analyst with nearly 30 years of experience, is celebrated for his quantitative expertise in quantifying investors’ sentiment to navigate Wall Street with a deeply rooted technical and contrarian trading style.